Answer to Question 2:

To permanently reduce the unemployment rate by increasing the rate of inflation, the government would have to permanently fool wage and price setters.

True or False?

The statement is true. The reduction in the unemployment rate occurs because the public does not realize that aggregate demand has increased. Once the public realizes that the equilibrium inflation rate has risen, the Phillips curve will shift up to pass through a vertical line representing the natural rate of unemployment at the new expected inflation rate. If people never learn, the reduction in the unemployment rate will be permanent. As the saying goes, however, you can't fool all the people all the time.

The government could prolong the period during which the rate of unemployment is reduced below the natural rate by escalating its monetary expansion faster than the public realizes it is escalating. But this will ultimately create hyperinflation and completely destroy the government's credibility.

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